Venture debt is a quasi-equity financing instrument for raising capital in the form of debt which can be used to supplement existing venture capital or finance specific opportunities (such as acquisitions) in the early growth stage of an enterprise. Venture debt providers offer loans to promising enterprises and in exchange receive warrants (rights to purchase future equity at a certain price) to compensate for taking on a higher risk of default. What makes venture debt an attractive option for the founders is its ability to minimise equity dilution (when capital is raised by issuing new shares, resulting in a reduction of stakeholder ownership percentage). With venture debt, the enterprise benefits from more favorable conditions such as more flexibility and lower interest rates. In return, the lender receives warrants on the company’s common equity.
When is venture debt a suitable investment option?
Venture debt is a good option for enterprises in their early growth stage which are already backed by venture equity and need a quick capital “boost” before the next funding round, but don’t want to further dilute their equity. This form of debt financing is typically provided to fund working capital or capital expenses, such as purchasing equipment. It is also a good option for promising early-stage enterprises that don’t qualify for traditional debt because they still don’t have access to positive cash flows or enough assets to act as collateral.
Despite its benefits however, it is an expensive option that should only be considered if you fit the right profile. You should not consider this form of investment if:
- You are not backed by venture equity;
- Your company has a low cash balance;
- You are unsure of your company trajectory;
- You can’t fully justify how the capital will be used;
- You need the capital for a long-term or substantial investment -in which case it would be more suitable to raise it through a new equity round;
- You haven’t yet found a satisfactory product-market-fit; and,
- You are not absolutely confident you will be able to repay your debt (within the repayment period which is typically 3-4 years).
If your company does have the right profile, however, this smart financing instrument can be useful and help your company grow and meet major milestones while allowing you to retain more ownership of equity, and therefore more control over your company’s trajectory.
To determine whether venture debt is the right financing option for your enterprise you must first understand what the benefits and the dangers are of this relatively new practice. Having a clear picture of your financing objective is a pre-requisite to decide whether you are a good fit for venture debt.
The following (non-comprehensive) characteristics and implications provide you with an overview to analyse the pros and cons for this investment instruments:
Early growth stage to later stage (the company should already have a product-market-fit)
The amount of venture debt raised is limited and is usually 20-35% of the company’s most recent equity financing round. It is usually raised alongside an equity round because the company’s creditworthiness and bargaining leverage are likely to be strongest at that point (CBinsights, 2020).
Pay-back period (Maturity)
Depends on the repayment structure agreed with the lender, but typically between 2-4 years. Re-payments usually start being made early on.
Use of funds
Although the use of funds is often unrestricted, it is generally advised that venture debt capital only be used for shorter term capital expenses (such as purchasing equipment) rather than large long-term investments, in which case it would make more sense to raise capital through venture equity.
Source: Adapted from (ROOTS OF IMPACT, 2020)
The following table summarises some key characteristics of venture debt and implications you should consider:
What does this mean for your enterprise?
Venture debt is usually raised to extend the cash runaway of a company (e.g., the amount of time a business has until cash runs out).
The main benefit is that this provides additional time for reaching major milestones via a cash buffer to put off further equity rounds until your enterprise receives a higher valuation score for future investors. Venture debt can thereby help to avoid or reduce further dilution. (CBinsights, 2020)
The lender receives warrants in exchange for accepting higher risk and more flexibility.
Warrants can be converted into common shares at the pre-agreed price in a future equity round. This means you have to duly consider the venture debt provider as a potential investor in your strategy for the next investment round.
Venture debt could be a cheaper way to finance equipment in a company
When venture debt is used to finance equipment (such as a water tank), more favorable terms including lower interest rates, no covenants etc. can be agreed on, since the equipment itself acts as collateral in case of default.
Unsecured. No collaterals, no positive cash flow needed.
Unlike debt, you are unlikely to be asked for collaterals or positive cash flows. This can be useful if your enterprise is relatively young and still lacking these. You are, however, expected to pay interest and have restrictive covenants.
Minimizes equity dilution.
This is one of the main drivers behind venture debt. Reducing dilution can allow you to retain more control over the trajectory of your company, since you don’t have new investors who accumulate shares and want a say in your company strategy or operations.
Adding a long-term liability with second payment priority after senior debt.
This is something to look out for if intending to launch future equity rounds. Future investors might be put off by the presence of too much debt in the company.
No equity is acquired and there is usually no board representation.
You can continue to manage your enterprise without having to engage and manage another shareholder.
Structuring venture debt tends to be a complex process.
The terms of the venture debt should be considered carefully by both parties. Structuring venture debt can be complex and might require you to hire a financial advisor, making the process more costly.
Venture debt allows flexible structuring and repayment schedule meaning that every venture debt contract will have its unique terms and characteristics.
It is up to you and your financial advisor to strike the right balance with your investor. Make sure that you are happy with the terms and that you are confident that you will be able to stick to the repayment schedule. Good negotiation skills will be crucial here but don’t forget to also be realistic about what you can and can’t do.
- Level of funding: The amount of Venture Debt raised is usually 20-35% of the company’s most recent equity financing round. It is usually raised alongside an equity round because the company’s creditworthiness and bargaining leverage are likely to be strongest at that point (CBinsights, 2020).
- Warrant: A warrant gives the lender the right (but not the obligation) to buy shares at a certain price before a predefined expiry date. It can be converted into common shares at the pre-agreed price in a future equity round. Warrant coverage typically ranges between 10% - 20% of the loan.
- Cash runaway: Cash runaway refers to the amount of time a business has until cash runs out. Venture Debt is usually raised to extend the cash runaway of a company. Thus, it can provide additional time in case of delays without increasing dilution.
- Perceived Risk: Although venture debt providers will usually be willing to accept a higher risk in exchange of warrants and interest, make sure you have cross-checked your investor’s risk assessment. There is a difference between the actual risk and the perceived risk of a company. Unfortunately, in cases where data is neither readily available nor the context of the company is properly understood, financial providers will base their assessment on perceived risk. This means that providers can often overestimate the risk levels of a company, resulting in less favorable conditions for the finance recipient when an investment is made. (UBA et al., 2020)
Tips to build your investment case as a young water-related enterprise
Once you have ensured that you are a good fit for venture debt, you must find out where and how to access it, including how you are going to approach investors and whether you will need to resort to de-risking instruments for improving your company risk profile. In order to successfully complete this final step, you must keep your eyes on the prize while thinking like an investor!
In order to be eligible for venture debt, you usually have to already be backed by venture equity, as it acts as a complementary financing instrument and not as a stand-alone financing option. If you are backed by venture equity, accessing venture debt will be more straight-forward than accessing traditional debt and, if used appropriately, will offer a lot more flexibility. Although you don’t necessarily have to provide collateral, remember that lenders will be expecting warrants as a compensation for accepting the higher risk of default (on top of the interest rates, of course).
Venture debt lenders are particularly interested in the future prospectus and viability of your company. They are accepting a higher risk because they believe that there is a lot of potential for growth. Having said that, potential is not the only factor they will rely on. Typically, venture debt lenders will only consider your profile if you are already generating strong revenues. The minimum revenue rate varies from lender to lender so make sure yours matches what the lender is asking for. In general, there are a few key requirements to qualify for venture debt (bearing in mind that only a small percentage of early-stage enterprises qualify for Venture debt):
- Be venture-backed (the venture debt lender wants proof that you will have enough capital to repay the debt and in the eventuality of a default, that the VC can bail you out)
- Have a secure market fit and stable revenue flows (recurring revenue is a big plus)
- Clearly demonstrated and predictable growth trajectory
- Be able to repay debt within a short period (typically between 2 -4 years) and a clear plan on how to do that
Prepare a strong case for yourself
When approaching a lender be prepared for questions and make sure you have the following:
- Your company profile, financial information and business model as well as a thorough market analysis ready to present to the lender.
- Set out your business goals as clearly as possible and your funding needs. There is no room for hesitation or uncertainty, the lenders want to know that you are in full control.
- How can you leverage on the lenders’ focus area? If the lender has a focus on innovation for example, how can you use the ‘innovation’ element in your enterprise to present a stronger case? Tip: although adapting your case to fit the lender criteria and profile preference is all part of the game, if you are having to adapt your profile significantly, you might risk what we call ‘mission drift’, which could potentially harm the future trajectory of your company.
- Who is your management team and why are they best suited for achieving your business objectives?
- Have a thorough plan for how you will service debt in the eventuality of a downside scenario.
Put yourself in your investor's shoes:
Since venture debt is a relatively new financing instrument, especially outside the tech sphere, you might need to do a bit of digging to find the right lender for your specific socio-environmental enterprise. Understanding who your potential lender is and what will spark their interest will help you present your case in such a way that raises your chances of being noticed. It is also important that you find out your lender’s reputation and make sure that you trust them and know what to expect in the event of a default or unexpected event.
Tips for finding out about your potential investors:
- See what areas they focus on and how you could leverage on them. For example, some of the focus areas of the European Investment bank are ‘Climate and environmental sustainability’ ‘Innovation’ and ‘Development’. If you were to prepare a pitch for them, a good idea would be to accentuate any elements of your BM that address these focus areas.
- Check what other enterprises they have financed in the past: do they have similar profiles to yours? What type of agreements and terms did they have? Could you see yourself as one of them?
- Since one of the benefits of venture debt is the flexibility that it can offer, check how much the potential investor could adapt to your unique case. Providing you have enough negotiation power you might be able to strike a good deal that suits your unique business characteristics.
Considerations for your investment case as a young water-related enterprise:
The main purpose and benefit of Venture Debt is to bridge cash flow gaps towards raising an investment round with high valuation. EquaLife Capital is one of several emerging private credit funds that provide alternative debt financing, including Venture Debt. EquaLife offers debt to companies with strong business fundamentals including existing positive cash flows, high growth potential, and innovative business models. EquaLife has raised a fund that is geared towards businesses which are seeing a temporary loss of revenue due to the COVID-19 crisis. Examples of appropriate businesses include agriculture businesses that pay farmers up front, before going to market or wholesale distributors, that buy from farmers, adding value to vegetables by cleaning and packaging, and sells to hospitality market. (FINDING IMPACT, 2020) In this line of thinking, technological solutions that require capital to facilitate end-user financing could benefit from venture debt.
As mentioned above, venture debt should ideally be used for financing working capital or capital expenses such as day-to-day operating expenses, payrolls or equipment. An organic waste management enterprise, for example, could use venture debt to pay for the operation costs of waste collection trucks (petrol and maintenance), expanding an already successful service, or costs associated with payroll. It would not be suitable, however, to invest venture debt in a new product or service, since its outcome would be unpredictable, or large and long-term investments such as a new warehouse that would take years to show any return on investment. Remember that with venture debt, repayments start shortly after you have received the capital so whatever you have invested in must see a return in the shorter term and be as predictable as possible. Similarly, enterprises working in wastewater treatment, for example, should not use venture debt for financing the building of a new treatment plant, since the return on investment would only be tangible years down the line.